The following is excerpted from a report by the Chief Investment Officer Team for Merrill Lynch Wealth Management. The team is headed by Lisa Shallet, CIO of Merrill Lynch Global Wealth Management and head of investment management & guidance.
In part (the fiscal cliff) is already here and Federal Reserve Chairman Benjamin Bernanke is on the job. A key point lost on investors, we believe, is that the U.S. economy has already been living with a fiscal drag of 1-2% annualized pace since the third quarter of 2010 as federal, state and local governments have been systematically retrenching. Factoring this in produces the reality that the private economy (businesses and consumers) has in fact been growing at a 2.5-3.5% real rate. Acknowledging that the individual consumption portion of the economy is running meaningfully below prior cycles — probably shaving another 1.6% from these figures — suggests that corporate America has been growing at roughly 4-5%.
This is in line with the recent second-quarter reporting season. One of our key themes over the past several years has been the divergence between the health of companies and that of governments and consumers (“buy companies not countries”). From our vantage point, that observation has caused us to look at corporate credit much more constructively as the new “AAA credits,” and to contextualize the U.S.'s sub-par and distinctive recovery this cycle. At roughly 1.5-2.0% total real gross domestic product (GDP) growth, many have suggested that the U.S. economy is operating below total capacity. While in aggregate that is true and the unemployment numbers are the clearest evidence of that, many commentators and politicians continue to miss the mix of issues that actually speak to the relative health of the corporate sector and the role that downsizing in government sectors has played in the outcomes. In addition to draining spending and investment from the economy from a GDP perspective, contraction in government (roughly 16% of all employment) at the federal, state and local levels has drained at least 2.2 million jobs from the totals (1.3 million of which have been at the local municipal level!) or more than 20% of the recovery's total! Interestingly, federal jobs are running 6.7% below their 55-year trend (beginning of the U.S. Bureau of Labor Statistics data series); state employment is 11.6% below and local is 8.5% below trend. While that doesn't in any way make up for the fact that industrial/service and manufacturing jobs are running at roughly 7.5% below historic trend (the equivalent of 8.9 million jobs this cycle) it is a material factor that typically doesn't occur during recessions. In fact, most recessions see stimulus take the form of government programs that increase employment. Perhaps more important is the question of whether the trends we are seeing in downsizing government and industry are in fact structural.
The recent JOLTS (Job Openings and Labor Turnover Survey) from the Bureau of Labor Statistics suggested that job openings continue to increase—in June by 105,000 on top of the 210,000 from May. Currently, total job openings are a whopping 3.762 million. Using an economic analysis called the Beveridge curve that plots the unemployment rate and job openings, one could suggest that the structural unemployment rate in the U.S. may have shifted in 2010 and today's steady state rate may have moved up from 5.5% to 7%. For perspective, in the past when job openings were at the relative level they are today, unemployment would have been closer to 6.5% than today's 8.3%.
The role of “fiscal drag” and “structural unemployment” is not lost on the U.S. Federal Reserve, and Bernanke is clearly prepared to hold his bullets until he has more visibility, not only on the speed of the economy, but the risks to it in 2013 from political gambles. We think that is why he is clearly keeping his powder dry on further quantitative easing. The point is that while the “fiscal cliff” is no doubt a threat and is causing a reduction in current spending, hiring and investment due to uncertainty (note recent capital goods orders are down for three months), we are less convinced that 2013 headwinds to growth will ultimately be much different than what we have already been battling, given that some lame duck Congressional action is still expected.
